US monetary regimes and optimal monetary policy in the Euro Area

Abstract:
Monetary policy in the US has been documented to have switched from reacting weakly to inflation fluctuations during the '70s, to fighting inflation aggressively from the early '80s onwards. In this paper, I analyze the impact of the US monetary policy regime switches on the Eurozone. I construct a New Keynesian two-country model where foreign (US) monetary policy switches regimes over time. I estimate the model for the US and the Euro Area using quarterly data and find that the US has switched between those two regimes, in line with existing evidence. I show that foreign regime switches affect home (Eurozone) inflation and output volatility and their responses to shocks, substantially, as long as the home central bank commits to a time invariant interest rate rule reacting to domestic conditions only. Optimal policy in the home country instead requires that the home central bank reacts strongly to domestic producer price inflation and to international variables, like imported goods relative prices. In fact, I show that currency misalignments and relative prices play a crucial role in the transmission of foreign monetary policy regime switches internationally. Interestingly, I show that only marginal gains arise for the Euro Area when the ECB adjusts its policy according to the monetary regime in the US. Thus, a simple time-invariant monetary policy rule with a strong reaction to PPI inflation and relative prices is enough to counteract the effects of monetary policy switches in the US.